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Chapter 1 What This Book Is About Introduction • 1930s , Keynes, John Maynard “The Theory of Employment Interest and Money” - Explain the working of the economy as a whole. - Employment vs Price - Government Policies This approach led to the development of two separate subjects, macro- and microeconomics. 2 The Modern Approach • More recently, economists have recognized that the methods used to study the behavior of individual producers and consumers in marketsmicroeconomics- can be used to study the working of the economy as a whole – macroeconomics. • This is so-called micro-foundation approach. • Example : Labor Market- supply and demand 3 4 Labor Supply and the Real Wage Figure 4.3 5 ©2002 South-Western College Publishing Labor Demand and the Production Function 6 Labor Market Equilibrium 7 The Three Major Questions • Business Cycle - 1930, Great Depression (U ↑ 25%, Y↓ 20%) which recovered until WWII. - 1970-80, 1990-2000, Oil Price Shocks - What causes economic booms and recessions? - Chapter 12. 8 Real GDP per Person 1890–2000 Great Depression Figure 1.1 9 ©2002 South-Western College Publishing Demand and Supply Shocks 10 The Three Major Questions • Real GDP Growth - The most important determinant of living standard. - Capitalist economics have been experiencing sustained growth for the past 200 years. - The theory of growth focuses on why economies produce more each year on average. - Chapter 15, 16, 17. 11 Real GDP per Person 1890–2000 Economic Growth Business Cycle Figure 1.1 12 ©2002 South-Western College Publishing The Three Major Questions • Inflation - The average rate of increase of prices. - Hyperinflation : Germany at the end of WWI, Iseral in 1985, Argentina in 1984. - What causes inflation? How to control? 13 Prices in the United States Since 1890 14 ©2002 South-Western College Publishing Economic Growth • Definition - Economic growth is a sustained increase in a nation’s standard of living. - It is measured by the average rate of change of the real gross domestic product per person. tn yt 1 t t1 yt g 1 n 15 Sustained Economic Growth is a Recent Phenomenon • The U.S. has been experiencing economic growth of about 1.9% per person for the past 100 years. • It’s a relatively recent phenomenon in the span of human civilization. • See Figure 1-3.(capitalist) 16 World Leaders in Output per Worker Since 1540 17 ©2002 South-Western College Publishing Measuring Economic Growth • Real GDP - a measure of the output available to an entire community. • Real GDP per person = Real GDP/ population • It is a usual measure of the standard of living. • It is highly correlated with a number of other indices. (Table 1.1) 18 Measuring Economic Growth • One should note that real GDP is not a perfect index. • For example, two countries with the sample real GDP per person but different in - Income distribution - Crime rate - Etc. i.e. this measure will miss quality-of-life. 19 Real and Nominal GDP • Nominal GDP measures the average dollar value of the goods produced in any year. • It can grow for either of two reasons: - The country produces more goods and services – increase growth. - Goods and services cost more money on average – inflation. 20 Real and Nominal GDP • To separate the increase in GDP that comes from growth, we measure the value of GDP in two consecutive years using a common set of prices- the base-year price. • GDP measured using the base-year price is called real GDP. 21 Comparing Standards of Living Across Countries • • Growth Rate Most countries , 1%~2% Some sub-Saharan African countries, -1% Japan, South Korea, China, 7%~8%. Cross-country differences in growth rates may seen like small numbers, but they can have quite a big impact – compounding. 22 Comparing Standards of Living Across Countries • Rule of Seventy - Used to gauge how fast a quantity will double in size. • Example Suppose you put $100 into a bank account with 5% annual interest. In (70/5)=14 years, you will have $200 in your account. 23 GDP per Person as a Percentage of U.S. GDP per Person in Four Selected Countries, 1960 to 1992 Figure 1.4 24 ©2002 South-Western College Publishing The Business Cycle • Definition The business cycle is an irregular, persistent fluctuation of real GDP around its trend growth rate. It is accompanied by the highly coherent comovements of many other economic variables. 25 Measuring The Business Cycle • Time series • Trend • When real GDP is below (above) trend for a number of time periods , the economy is in a contraction (boom) or a recession (expansion). 26 Trends and Cycles • Many macro variables display upward trends, like GDP, prices and consumption. • In order to investigate the relationships between the business-cycle fluctuations of two or more time series, we need to detrend the series. • Detrending: see Figure 1-5. 27 Random Fluctuations Around a Constant Trend Figure 1.5 28 ©2002 South-Western College Publishing Recession, Expansions and the NBER • NBER defines a recession as a recurring period of decline in total output, income, employment and trade, usually lasting from six months to a years, and marked by widespread contractions in many sectors of the economy. • Sometimes growth may slow down but GDP will not decline – “Growth Recessions”. 29 NBER Dating of Business Cycles Since 1948 Figure 1.6 30 ©2002 South-Western College Publishing Coherence and the Business Cycle • The business cycle has an important random component. • Although economic variables move in an irregular way through time, many of them move very closely in tandem - coherence. • Variables move in the same direction as GDP over the cycle are said to be procyclical. • Variables move in the opposite direction to GDP over the cycle are said to be countercyclical. 31 Procyclical and Countercyclical Variables Figure 1.7 32 ©2002 South-Western College Publishing Persistence and the Business Cycle • A second distinguishing feature of economic variables is their high degree of inertia through time - persistence. • By identifying the reasons for the coherence and persistence, economists hope to explain why recessions occur and how they can be controlled. 33 The Social Dimension of Business Cycles • There are many other social indicators that have a business-cycle dimension. - Violent crime, poverty, the unemployment rate, and unemployment duration. 34 Why Business Cycles Matter Figure 1.8 35 ©2002 South-Western College Publishing Inflation • Definition: Inflation is a sustained increase in the average price level, measured by percentage rate of change of one of several commonly used price indices. 36 Measuring Inflation • - Different indices of the average price level: The consumer price index (CPI) The producer price index (PPI) The GDP deflator The GDP price index The PCE price index (personal consumer expenditure) - A negative inflation rate - deflation 37 Inflation and the Price Index Figure 1.9 38 ©2002 South-Western College Publishing Inflation and the Central Bank • Inflation is widely accepted as being caused when a country increases its money supply faster than the rate of increase of money demand. • The control of inflation is viewed as a problem for the central bank. 39 The Benefits of Low Inflation • When inflation is low, most prices do not change very often. • Then households and firms can easily estimate future relative prices and make decisions. • Interest versus Inflation 40 Economic Theory and Economic Facts • Classical Economics and the Quantity Theory of Money - Inflation and monetary system - Chapters 4, 5, 6. • Involuntary Unemployment and the Great Depression (Keynes Model) - Short run, IS-LM - Chapter 7 - 12 41 Economic Theory and Economic Facts • The Resurgence of Growth Theory - Neoclassical and Endogenous Growth Theory - Chapter 14-16 • Rational Expectations and Modern Dynamic Theory - Phillips curve, Dynamic AD-AS - Chapter 17, 18 42 Homework Question 5, 6, 10 43 END